Prime Rate

Posted in Finance, Accounting and Economics Terms, Total Reads: 1058

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Definition: Prime Rate

Prime rate is the interest rate charged by a bank from its most trustworthy customers. Usually, a bank maintains a range of interest rates. Before offering a loan, a detailed study of creditworthiness of the customer is performed.

Then, an appropriate interest rate is offered to the borrower. Among all these borrowers, those who have the best track record of creditworthiness and thus possess a negligible risk of default are offered the lowest rates, called the ‘prime rate’. Thus, if viewed from the opposite perspective, the bank formulates the prime rate as an incentive for the customers to induce them maintain good creditworthiness (which, in turn, is beneficial for the bank).

Significance:

The prime rate is an important determinant for calculating returns on other debt instruments. Short-term bonds and adjustable rate mortgages use prime rate as index for their interest rates. Credit cards also add a spread to the prime rate to calculate their interest rates. Loans for small business and personal loans are also affected by the prime rate.

In US, the prime rate is defined as 300 basis points (3 percentage points) plus the federal funds rate (rate for overnight interbank loans). The current prime rate is 3% in US. It can also be mentioned that, with passage of time, banks now sometimes offer rates even below the prime rate depending on some other factors.